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Figure 24.1 (Macro 11) The Aggregate Demand Curve

Figure 24.1 (Macro 11) The Aggregate Demand Curve

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Between Inflation Interest Rate and Real GDP



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Showing Relation of

Interest Rate to

Investment



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STAGE I: Interest rate and Investment



• As real (inflation-adjusted) interest rate

goes up, cost of borrowing goes up, so that

business investment (buying a new machine

or extending business) and housing

investment declines.

• As real interest rate declines, investment

goes up, because the cost of investment

declines



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Showing Relation of

Interest Rate to Net

Exports



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Interest Rate and Net Exports

• If US interest rates increase, it becomes

more attractive to invest in the US,

compared to other countries such as Canada

or Mexico, our top trading partners.

• This raises the demand for US dollars and

appreciates the US dollar against other

currencies like Canadian $s or Mexican

pesos.

• This hurts our exports but raises our

imports.

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Interest Rate and Consumption Expenditures



• Evidence indicates that consumption is less

sensitive to interest rate changes than

investment and net exports

• In general, higher interest rates encourage

people to save more (consume less),

indicating an inverse relationship between

interest rates and consumption

• Figure 24.2 shows the net impact.

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Figure 24.2

(Macro 11)

The Interest Rate, Spending Balance, and Real GDP



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STAGE II: Interest Rates and Inflation

• So far we have seen how real interest rates

affect real GDP.

• Now we want to study how inflation affects

interest rates.

• Real interest rate = nominal interest rates

minus expected inflation rate

• Note that it is the real interest rate that we

use to decide about our spending plans

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Figure 24.1 (Macro 11) The Aggregate Demand Curve

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